Last month, I wrote an article asking whether, given the strong run that we’d seen in US stocks over the past nine months, Europe might be due its time in the sun. I focused on valuations and what might be driving them, looking particularly closely at GDP growth and the position of high-growth technology stocks in each region. I mentioned in passing the significant role that share buybacks play in US stock valuations and wondered whether European firms’ reluctance to use them might change. Seizing upon this, and drawing further on research from Morgan Stanley and Goldman Sachs, one of our portfolio managers, Fabio Pecce, delved deeper into the question of European stocks and management motivation, coming up with some interesting conclusions.
I thought I’d summarize Fabio’s findings, beginning with the observation that CEOs of many leading US firms remain markedly more focused on shareholder returns than their European peers. Indeed, they are incentivised to be this way: nearly 80% of US companies link CEO compensation to some share price-related metric. In Europe, the numbers have historically been much lower, but although they currently range from as low as 15% in Spain to around 50% in Germany, the trend is definitively upwards1. It’s our belief that increasingly share price-focused management teams in Europe are going to be important drivers of performance in the coming months and years.
Certainly the CHF20bn Nestle share repurchase that was announced at the end of June this year has caused many investors to look again at the possibility of European buybacks as a potential tailwind for earnings growth. In that specific case, many have speculated that management’s hand may have been forced by pressure from activist investors, but even without such direct encouragement, we believe it is likely that corporations will increasingly employ buybacks in Europe. In an article entitled Time to Buy(Back)?2, Goldman Sachs listed a range of dynamics supporting buyback activity, from the CEO pay structures linked to share price, increased cash flows, the currently cheap cost of credit and more solid balance sheets. They also cited a reduction in political risk since the French elections. Indeed, we believe that with the risk of euro break-up reduced following recent elections in Holland and France, management teams are finding the cash buffers they hold in case of another crisis increasingly difficult to justify.
What is clear to us is that, for cultural and historical reasons, European corporations haven’t used buybacks anything like as enthusiastically as their US peers. Since 2009, buybacks have accounted for a quarter of cumulative EPS growth in the US, while in Europe the equity gap (capital increases minus buybacks) had a negative impact on EPS. US corporations used 23% of their cash balances in 2016 for buybacks, while in Europe the figure was 5%3. The graph below gives striking evidence of the untapped potential that exists for European buybacks.
Figure 1. STOXX Europe 600 ex-Financials buybacks level is considerably lower compared to S&P 500
Source: FactSet, Goldman Sachs Global Investment Research, July 2017.
It’s worth considering the substantial contribution that buyback activity makes to US EPS growth. Without this turbo-charging of returns, US EPS growth over the past two years would actually have been negative. Europe, on the other hand, is seeing growth in earnings, and we believe there exists potential for accelerating this further through buybacks. What’s more, those companies that have carried out buybacks in Europe have seen marked outperformance: 38% versus their peers in the past five years4. And it may be that we’re already moving towards an inflection point. As the Figure 2 shows, the equity gap is beginning to close in Europe as we see fewer large rights issues and more M&A and buyback activity.
Figure 2. Equity supply gap starts to close – percentage of market cap increase/decrease in net equity supply per year
Source: Datastream, Goldman Sachs Global Investment Research, 5 July 2017. Note: equity supply is the change in market cap not accounted for by price.
Let’s turn now to another potential driver of returns in Europe – M&A activity. Europe is a notable outlier in terms of global M&A action so far this year. The value of deals targeting European firms rose 18% in the first half of 2017 (after a strong second half to 2016) versus the US, which saw a drop in activity of 13%5. Importantly, Europe is still running at around 50% of its 2006-7 peak, while the US has already surpassed those highs. We believe this is another powerful indicator of as-yet-untapped potential in the European markets.
It’s important also to look at who is driving the current M&A activity in Europe, with 25% coming from private equity deals, a potential sign that opportunistic investors are increasingly seeing value in European assets6. Large cross-border deals will always attract regulatory scrutiny in Europe, but while many would hold up the apparent failure of Kraft Heinz’s bold approach to Unilever, or PPG walking away from its attempts to buy Akzo Nobel, we’d highlight Johnson & Johnson’s purchase of Actelion and the USD43bn tie-up between Syngenta and ChemChina. Beyond regulation, we find that sometimes it’s just a matter of how committed the acquirer is to the transaction – history has shown us that with wholehearted conviction, even century-old companies can adapt their approach take more shareholder-friendly actions.
Which brings us back to buybacks and motivated management teams. Because a pick-up in M&A activity will necessarily focus management teams on protecting themselves from aggressive acquirers, or at least on ensuring the best possible deal for their shareholders. With activist investors circling and private equity driving more deals that ever, the European landscape is changing. Those management teams that don’t recognize this and react accordingly could find themselves left on the sidelines. For us, all of this supports the case for broader optimism about the prospects for European stocks in the coming months and years.
1. Goldman Sachs Portfolio Strategy Research, “Strategy Matters. Time to buy(back)?” 5 July 2017.
4. Source: Morgan Stanley Research, 13 July 2017.
5. Source: Morgan Stanley Research, 30 June 2017.